Liquidity preference

Liquidity preference, in economics, the premium that wealth holders demand for exchanging ready money or bank deposits for safe, non-liquid assets such as government bonds. As originally employed by John Maynard Keynes, liquidity preference referred to the relationship between the quantity of money the public wishes to hold and the interest rate. According to Keynes, the public holds money for three purposes: to have on hand for ordinary transactions, to keep as a precaution against extraordinary expenses, and to use for speculative purposes. He hypothesized that the amount held for the last purpose would vary inversely with the rate of interest.

The most significant point about Keynes’s theory is that, at some very low interest rate, increases in the money supply will not encourage additional investment but instead will be absorbed by increases in people’s speculative balances. This will occur because the interest rate is too low to induce wealth holders to exchange their money for less liquid forms of wealth and because they expect interest rates to rise in the future. The concept of liquidity preference was used by Keynes to explain the prolonged depression of the 1930s.

Post-Keynesian analysis, in which the classification of liquid assets has been broadened, has tended to relate the demand for money to a wider array of variables; these include wealth and the various forms in which it is held, the yields of these different forms, and the level of income, as well as the interest rate.